Rational Advisor

As we step into 2008, I’ll be posting some of my thoughts based. Much of these are through discussions with various investment specialists, and some are my own thoughts

One of the things that can adversely affect our financial well being is a market crash. they seem to come out of no where, and when least expected. Since there has been no one that has proven to me the ability to predict when a crash will happen, I prefer to think that it can happen anytime, and be in preparation for it.

There are two approaches to the future, 1) Prediction and 2) Protection.

I don’t think anyone including the Oracles, tarot card readers, palmists, astrologers -r Financial analysts have demonstrated any long lived track record fo predicting the future. So, i will refrain from really doing that. Later on, I will share ideas of others and what they think will happen.

But, personally, I tend to believe in #2 - Protection, ie thinking of the worst possible events and building a portfolio that will be offer the most protection from these events (note: you cannot eliminate the possiblity of all events - no matter what the newspapers tell you).

As such, we need to study past market crashes, particularly the more recent ones’ to determine what would have been decent protection, instead of indecent greed!

The two periods 1987 and 1998 - bear some resembelence to the present. Both were periods when the markets did well.

The 1987 crash took place during the original buyout boom (we saw a similar thing in late 2006 and early 2007 as Private Equity, and now Sovereign investments are doing their purchases).

The 1998 crash was due to the first big hedge-fund implosion, which forced the fed to step in to calm credit markets (similar to what they are doing today with Banks that were led to a credit crunch by the Bear Stearns Hedge funds collapse due to sub-prime)

In 1998, the Feds would up intervening three times, becasue its first intervention was insufficient. In 1987, the Feds did not intervene till it was too late, although in both cases their actions did stop the bleeding.

This time, we are seeing hedge funds using mathematical models - contributing to huge market swings and massive trasing volumes. Emember the hedge funds are more focussed on shorter term returns, and are more leveraged, so are very reactionasry to market events. These hedge funds are doing the same thing that programmed traders were doing in 1987, and Long Term Capital Management were doing in 1998. Although we’ve seen some fall out, we haven’t seen the pen-ultimate event yet, that will scare fo these hedge funds, much like the scaring off of programmed traders, and the collapse of Long Term Capital. In 1987 the models were known as portfolio insurance (LOL!!). More like Insurance for the brokerage firms and not for their clients - Margin calls were the after effect that led to the ruin of many
previously sophisticated genius irrational investors (the Public!)

In all previous crashes, it’s been investors over-confidence and the use of borrowed money into “hot” sectors that has led to the problems.

Another big lesson of all market crashes is that the debt markets often posed the biggest threats to stability. In 1987, investors borrowed to invest in the markets and over-borrowed, then the rising interest rates to slow the growth led to the 1987 crash (much like the belief in China, and their need to increase interest rates to slow down their economy). Also, in 1987 it was huge investment funds that used junk bonds to takeover companies. In 1998, it was the risk of the amount borrowed by firms such as Long Term Capital. Lately it’s securities backed by mortgages.

Booms in markets generate laxity in standards for loans because there is a general sense of optimism. That is what we saw in the 1980’s, 1990’s and now.

Also in 1987, like now there was a strong world economy and healthy corporate profits, which investors like today with China and India think will last for years. In the previous market crashes the stock market declines shook these hopes back to reality.

In all previous market crashes, the markets became increasingly volatile towards their end. Sharp drops proved to be temporary affairs as the recovery from them created a false sense of optimism. Many times the hottest investments had the greatest recovery from these downturns, and investors incorrectly surmised that they were the better investments, and piled more heavily into them. We are seeing similar things now, as the volatility makes certain funds recover from a downtick faster, investors are jumping on those funds, instead of those that have NOT recovered as well (which in fact are the better ones to be in).

What are the differences between now and the past market crashes - valuations (although when you do an analysis, you’ll realize once you normalize the earnings, they are still high).

The real excess this time has been in the lending markets, where investors bid up mortgage related securities and junk bonds to unheard of levels (apparently Canadian’s think there real estate is immune from global events - we have this invisible force field around us! I think not!).

A good sign is that in 1987 and 1998 the markets woes were severe but brief. They fell 36% and 20% respectively. But both years the markets finished positively.

Also concerning was that the receovery from these falls - the following boom lasted about two years 1987 - followed by the buyout boom and real estate bust in 1989, and for 1998 it was followed by the tech wreck in 2000.

So, what did get through all these crashes without having being impacted much - simply Bonds and Large Cap companies that offer dividends - everytime, even though the year (years) before the corrections they seemed like the dumbest investments, because their returns were “too low”

Wake up, and smell the coffee/Roses

Rational

As we think about the boxing day sales

A man is walking down the street when he meets a friend who happens to have only one arm.

“What are you up to today?” he asks his friend.

“I’m going to change a light bulb.”

“Won’t that be difficult with just one arm?”

“Shouldn’t think so. I’ve got the receipt.”

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